How Do Bonds Perform When Interest Rates Spike?

Wesley Gray |

The prediction of higher interest rates has been ongoing since the government went all-in on a variety of so-called “inflationary” efforts. Inflation hasn’t happened, and rates are still low across the yield curve. So-called “bond vigilantes,” having been wrong for seven straight years now, and are still calling for inflation and subsequent higher interest rates. Will higher interests happen? I don’t know. Regardless, the point of this piece is not to pontificate on where interest rates will go, but to look back in time and assess what happens when interest rates have risen dramatically.

Before addressing this question, let’s take a look at historical yields.

Visualizing 110 Years of Treasury Yields:

The figure below shows the US 10-year treasury bond rate from 1900 to 2015. We can see that, historically, the Fed has hiked rates to control high inflation, and has lowered rates to stimulate the economy. During the early 1980s recession, inflation rose to double-digit highs, and Paul Volker and Fed took the proverbial “punch bowl” away, raising rates to over 15%. It was at this point, in 1981 that the 35-year bull market for bonds began.

US_10___Year_Treasury_Interest_Rate___11_18.jpg

The U.S. 10-year treasury bond interest rate history_The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

From 9/1981 (interest rate peak) to 9/2015, the compounded annualized growth return (CAGR) for US 10-year Treasury bond was 9.15%, with an attractive Sharpe ratio of 0.6. Over the same period, the CAGR for SP500 was 11.43%, with a Sharpe ratio of 0.52. The worst drawdown for the US 10-yr bond was only -10.51% while for the SP500 it was a staggering -50.21%.

Graph_I___11_18.jpg

Bull run of bond market since 1981_5 assetsThe results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Today, rates are at historically low levels, but investors think this can’t last very long (even though the market has predicted rate hikes for the past five years.)

Finally, here is a chart of bond performance and inflation. As expected, there is a negative relationship between bond performance and inflation.

With some baseline stats out of the way, now we can ask the question: What happens to bonds when interest rates spike?Bond Performance and Inflation

Bond_Peformance_and_Inflation___11_18.jpg

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The Trials and Tribulations of the 10-Year Treasury Bond

We calculate the rolling 3-year % change of 10-yr treasury bond rate from 1900 to 2015, and add it to below chart. The data is from Robert Shiller’s Website. The top hikes and top troughs are circled. We want to see how bonds performed during these special, volatile environments:

Trials_and_Tribulations___11_18.jpg

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Our study includes 5 asset classes over the sample time period:The trials and Tribulations of the 10-year Treasury Bond_

  • US 5 YR: US 5-year Government Bond Total Return Index
  • US 10 YR: US 10-year Government Bond Total Return Index

  • US 30 YR: US 30-year Government Bond Total Return Index

  • US Corp Bond: Dow Jones Corporate Bond Total Return Index

  • SP500: SP500 Index

  • CPI: Consumer Price Index

Bond Performance in Rising Rate Environments

Based on the 10-year rate, we pick the top five rate hikes and see how bonds performed during these spikes.

Sept 1978 to Sept 1981: 8.42% –> 15.32% (up 82%)

This is clearly a big move. So what happened?

Bond suffered poor nominal returns, but not gut-wrenching. Also, note the change in the CPI over this period: real-returns are pretty gut wrenching. Short-term bonds and Mid-term bonds do relatively better because of lower duration.

Graph_II___11_18.jpg

Jan 1967 to Jan 1970: 4.58%–>7.79% (up 72%)period 1_sept 1978 to sept 1981

Graph_III___11_18.jpg
 

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Poor nominal returns, but not as bad as above. As before, real-returns are still tough. Again, short-term bonds and mid-term bonds do relatively better because of lower duration.

July 1954 to July 1957: 2.30% –>3.93% (up 71%)period 2_Jan 1967 to Jan 1970

Poor nominal returns and extremely poor returns relative to equity. Real returns are painful. Again, short-term bonds and mid-term bonds do relatively better because of lower duration.

Graph_IV___11_18.jpg
 

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

June 2003 to June 2006: 3.33%–>5.11% (up 53%)period 3_July 1954 to July 1957

Poor nominal returns, and especially poor returns relative to equity. Real returns painful. As before, short-term bonds and mid-term bonds do relatively better because of lower duration.

 

Graph_V___11_18.jpg
 

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

July 2012 to July 2015: 1.53%–>2.32% (up 53%)period 4_June 2003 to June 2006

 

Graph_VI___11_18.jpg
 

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Indifferent nominal and poor real returns, but extremely poor returns relative to equity.

Takeaway: During the largest spikes in interest rates, bonds endure pain and these events are scary, but the pain can be quantified and the results aren’t as “scary” as some market commentators suggest. Also, the results emphasize that owning a mix of stocks and bonds is important from a diversification standpoint.period 5_July 2012 to July 2015

Bond Performance in Falling Rate Environments

Based on the 10-year historical rate, we pick the top 4 peaks for rates and see how bonds performed during these falling rate environments.

June 2009 to June 2012: 3.72%–>1.47% (down 60%)

Great Performance. Long-term bonds perform better because of longer duration. Corporate bonds perform well too.

Graph_VII___11_18.jpg
 

period 1_June 2009 to June 2012

 

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

June 2000 to June 2003: 6.10% –>3.33% (down 45%)

Great absolute and real performance; especially relative to equity.

Graph VIII - 11-18_1.jpg
 

period 2_June 2000 to June 2003The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Sept 1990 to Sept 1993: 8.89%–>5.36% (down 40%)

Great Performance. Long-term bonds perform better because of longer duration.

 
Graph IX - 11-18_1.jpgperiod 3_Sept 1990 to Sept 1993

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Aug 1983 to Aug 1986: 11.85% –>7.17% (down 39%)

Great Performance. Long-term bonds perform better because of longer duration.

Graph_X___11_18.jpg

period 4_Aug 1983 to Aug 1986The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Takeaway: As expected, bonds perform well in falling interest rate environments.

Conclusion: Avoid "Fear Instincts"

Who knows where interest rates will go–they could go down 50%, or they could go up 50%. The exercise above helps us quantify how big interest rates look in practice, and how they might affect a portfolio. This data-driven approach is important because it prevents investors from indulging in “fear-based” responses to market commentators who suggest we put all our capital in gold bars buried in our backyard, or on the opposite spectrum, the market commentators who suggest we put all our capital in 30-year zero coupon treasury bonds.

And one comment on the “bury gold bars in the backyard” trade, which would likely be associated with a hyperinflation doomsday-like scenario. We need to understand the context of that environment when/if it ever happened. Basically, from a financial markets perspective we are all dead: bonds are dead; stocks are probably dead; and corruption/barter will rule the land. Unfortunately, gold bars buried in the back yard won’t be the savior, because people with guns (or the government) can steal the gold from those who buried it in their backyard. Having lived and operated in countries that operate in this manner, I don’t think everyone in the “bury gold in your backyard” crowd really understands how that trade would pay off in practice. In many respects, the gold bar trade is akin to the “buy CDS” trade in 2007. Good idea in theory, but when you go to cash-in your insurance from AIG, you find out they are bankrupt and you are left holding the bag (until the government bailed you out).

Long story short, investors would be better served by avoiding “fear instincts” and sticking with simple diversified portfolios with principles outlined in our robust asset allocation framework. Include stocks, include bonds, include inflation-friendly assets, minimize taxes/fees, and so forth. And for those with a more extreme survivor-mentality, keep a small amount of capital dedicated to gold and guns, but don’t tell anyone about it and pray that it never has to pay off.

How Do Bonds Perform When Interest Rates Spike was originally posted by Wesley R. Gray at Alpha Architect. Please read the Alpha Architect Disclosures at your convenience.  

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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